Mastering The Market Cycle: Getting the Odds on Your Side

by Howard Marks

I lean heavily toward the first definition: in my view, risk is primarily the likelihood of permanent capital loss. But there’s also such a thing as opportunity risk: the likelihood of missing out on potential gains. Put the two together and we see that risk is the possibility of things not going the way we want.

He doesn’t fully understand the nature and importance of cycles. He hasn’t been around long enough to have lived through many cycles. He hasn’t read financial history and thus learned the lessons of past cycles. He sees the environment primarily in terms of isolated events, rather than taking note of recurring patterns and the reasons behind them. Most important, he doesn’t understand the significance of cycles and what they can tell him about how to act.

When the cycles are positioned propitiously, the probability distribution shifts to the right, such that the outlook for returns is now tilted in our favor. Our favorable position in the cycles makes gains more likely and losses less so.

But when the cycles are at dangerous extremes, the odds are against us, meaning the likelihoods are less good. There’s less chance of gain and more chance of loss.

Globalization —The integration of nations into a world economy may add to total world economic output, in part because of benefits from specialization, or it may not, leaving it a zero-sum (or negative-sum) exercise. But clearly, globalization can have differential effects on individual nations’ economies (and create winners and losers within each nation). The massive increase in the

number of factory workers described above

certainly accelerated China’s economic growth over the last thirty years by permitting it to become a leading exporter to the rest of the world. However, that same trend caused developed nations to buy a lot of goods from China that they otherwise might have produced themselves, thus curtailing their own GDP. The few million manufacturing jobs estimated to have been lost to China since 2000 certainly made U.S. economic growth lower than it otherwise would have been, although one would nee...

I returned to the topic in “It’s All Good” (July 2007). Before going on to make a new observation, I listed a half-dozen additional elements in which pendulum swings are seen: between greed and fear, between optimism and pessimism, between risk tolerance and risk aversion, between credence and skepticism, between faith in value in the future and insistence of concrete value in the present, and between urgency to buy and panic to sell.

Strong economic data is seen as likely to make the Fed withdraw stimulus by raising interest rates, and weak data is taken to mean companies will have trouble meeting earnings forecasts.

other words, it’s not the data or events; it’s the interpretation. And that fluctuates with swings in psychology.

Again, the superior investor—who resists external influences, remains emotionally balanced and acts rationally—perceives both positive and negative events, weighs events objectively and analyzes them dispassionately. But the truth is that sometimes euphoria and optimism cause most investors to view things more positively than is warranted, and sometimes depression and pessimism make them see only bad and interpret events with a negative cast. Refusing to do so is one of the keys to successful investing.

For me, the bottom line of all this is that the greatest source of investment risk is the belief that there is no risk. Widespread risk tolerance—or a high degree of investor comfort with risk—is the greatest harbinger of subsequent market declines. But because most investors are following the progression described just above, this is rarely perceived at the time when perceiving it—and turning cautious—is most important.

The ability to borrow large amounts of capital at low interest rates caused asset

buyers to consider the period a “golden age.” But it wasn’t marked by the availability of sound, bargain-priced investments. Rather, the ready availability of leverage made it easy to invest heavily in assets whose prices had risen a great deal, and in innovative, untested, synthetic, levered investment products, many of which would go on to fail.

The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.

are willing to part with it can apply rigorous standards, insist on strong loan structures and protective covenants, and demand high prospective returns. It’s things like these that provide the margin of safety required for superior investing. When these boxes can be ticked, investors should swing into an aggressive mode.

The slammed-shut phase of the credit cycle probably does more to make bargains available than any other single factor.

the rise and fall of the distressed debt cycle. Here it is:

Risk-averse investors limit quantities issued and demand high quality. High-quality issuance leads to low default rates. Low default rates cause investors to become complacent and risk-tolerant. Risk tolerance opens investors to increased issuance and lower quality. Lower-quality issuance eventually is tested by economic difficulty and gives rise to increased defaults. Increased defaults have a chilling effect, making investors risk-averse once more. And so it resumes.

Over the course of my career I’ve heard investment in real estate rationalized by easily digested statements like “they’re not making any more” (in connection with land), “you can always live in it” (in connection with houses), and “it’s a hedge against inflation” (in connection with properties of all types). What people eventually learn is that regardless of the merit behind these statements, they won’t protect an investment that was made at too high a price.

Bad times cause both the level of building activity to be low and the availability of capital for building to be constrained. In a while the times become less bad, and eventually even good. Better economic times cause the demand for premises to rise.

With few buildings having been started

during the soft period and now coming on stream, this additional demand for space causes the supply/demand picture to tighten and thus rents and sale prices to rise. This improves the economics of real estate ownership, reawakening developers’ eagerness to build. The better times and improved economics also make providers of capital more optimistic. Their improved state of mind causes financing to become more readily available. Cheaper, easier financing raises the pro forma returns on potential projects, adding to their attractiveness and increasing developers’ desire to pursue them. Higher projected returns, more-optimistic developers and more-generous providers of capital combine for a ramp-up in building starts. The first completed projects encounter ...

planned, financed and green-lig...

are ordered from the factory, but that’s a different cycle). It takes years for the buildings started later to reach completion. In the interim, the first ones to open eat into the unmet demand. The period between the start of planning and the opening of a building is often long enough for the economy to transition from boom to bust. Projects started in good times often open in bad times, meaning their space adds to vacancies, putting downward pressure on rents and sale prices. Unfilled space hangs over ...

And if conditions change materially in the relatively brief interim, the lender may be able to pull his commitment under a “material adverse change” provision in the contract. Thus there’s relatively little risk in general lending resulting from the gap between idea and action.

the first stage, when only a few unusually perceptive people believe things will get better, the second stage, when most investors realize that improvement is actually taking place, and the third stage, when everyone concludes things will get

better forever.

“What the wise man does in the beginning, the fool does in the end.”

Assessing our cycle position doesn’t tell us what will happen next, just what’s more and less likely. But that’s a lot.

In situations that have thinking participants, the participants’ . . . distorted views can influence the situation to which they relate because false views lead to inappropriate actions. (“Soros: General Theory of Reflexivity,” Financial Times, October 26, 2009)

All it takes for the perpetual motion machine to grind to a halt is the failure of one or two assumptions and the operation of some general rules:

Interest rates can go up as well as down. Platitudes can fail to hold. Improper incentives can lead to destructive behavior. Attempts to quantify risk in advance—particularly as to novel financial products for which there is no history—will often be unavailing. The “worst case” can indeed be exceeded on the downside.

the Fed had reduced the base rate of interest to very low levels in order to ward off the depressing effects of the tech bubble’s bursting, as well as concern over Y2K; because of the low yields available on Treasurys and high grade bonds, as well as the disenchantment with equities that had resulted from their three-year decline in 2000–02, investors were eager to put money into alternative instruments; investors had shrugged off the pain of the collapse of the tech bubble in 2000 and the telecom meltdown and corporate scandals

of 2001–02; thus little risk aversion was present (especially in areas other than equities, which remained out of favor), rendering investors generally eager for investments in exotic, structured and synthetic instruments; and as a result of all the above, the markets were wide open for the issuance of low-quality debt, poorly structured instruments and untested alternatives.

But, on the other hand, the investor also has to know his limitations and not assume he’s infallible. He has to understand that no one knows for sure what the macro future holds. While he’s likely to have opinions regarding the future course of economies, markets and interest rates, he should acknowledge that they’re not necessarily

correct. And, counter to the above, he mustn’t always

assume that he’s right and the market’s wrong—and thus hold or add without limitation and without rechecking his facts...

The basic reason for the cyclicality in our world is the involvement of humans. Mechanical things can go in a straight line. Time moves ahead continuously. So can a machine when it’s adequately powered. But processes in fields like history and economics involve people, and when people are involved, the results are variable and cyclical. The main reason for this, I think, is that people are emotional and inconsistent, not steady and clinical.

Investors tend to look at the processes that are afoot, attribute mechanical dependability to them, rely on that dependability, and extrapolate the processes. What they overlook is the role of emotions: greed on the upswing and fear on the downswing.